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Non-U.S. boards of trade and U.S. regulatory reform

The Obama administration recently delivered legislative language to Congress on reforming regulation of the markets in over-the-counter (OTC) derivatives.1 The proposed legislative language, entitled The Over-the-Counter Derivatives Markets Act of 2009 (“OTC Act of 2009”), is intended to comprehensively regulate the OTC derivatives markets and follows the broad outlines of the administration’s White Paper on Regulatory Reform, released on June 17, 2009. Non-U.S. futures exchanges (“Foreign Boards of Trade” or FBOT) should be aware that certain provisions of the OTC Act of 2009, if enacted, will affect the terms under which direct market access to FBOTs by their U.S. members or participants is permitted.

What is the current procedure governing direct market access by U.S. members or market participants of a Foreign Board of Trade?

Over-the-years, staff of the Commodity Futures Trading Commission (CFTC) has granted a number of no-action letters permitting direct market access by members of an FBOT located in the United States. The CFTC has promulgated a Policy Statement explaining that the staff grants such relief upon a demonstration that the non-U.S. exchange is a bona fide foreign board of trade and that granting the requested no-action relief is in the public interest. The policy statement details the information that must be included by the FBOT in making that demonstration.2

The Policy Statement, at page 64449, also provides that special responses, “such as imposing conditions and requiring enhanced information sharing arrangements and surveillance procedures, or other appropriate action,” should be taken by the commission staff if it becomes aware that the trading of products listed on an FBOT that has been granted no-action relief

adversely affects the pricing of contracts traded on any registered entity—or of contracts traded on any cash market for commodities subject to the CEA;

creates unacceptable systemic risks or disruptions in those markets or the U.S.A. financial system, including capital markets; or

facilitates abusive trading practices on U.S. markets or otherwise interferes with the ability of the CFTC to carry out its regulatory responsibilities, in particular market surveillance.

The CFTC staff has issued 36 letters addressing direct market access by members of an FBOT located in the U.S.3

How will the proposed OTC Act of 2009 change the current procedures?

Section 725 of the proposed OTC Act of 2009 would authorize the CFTC to adopt rules requiring an FBOT that permits direct market access to its electronic trading and order matching system by members or market participants located in the United States to register with the CFTC.

In addition, unless the FBOT meets specified conditions, Section 725 of the proposed OTC Act of 2009 would prohibit direct market access by members or market participants located in the United States to any contract traded on an FBOT that settles to the price of one or more contracts traded on a U.S. exchange or cleared on a U.S. clearing house. The conditions which would apply to these linked contracts are as follows:

The FBOT must make public daily trading information with respect to such linked contracts that is required to be made public by the U.S. market;

The FBOT must adopt speculative positions limits comparable to those that apply to the linked U.S. contract;

The FBOT must have authority to require direct market participants to limit, reduce or liquidate a position that the FBOT or its regulator determines to be necessary to prevent or reduce the threat of price manipulation, excessive speculation, price distortion or disruption of delivery or the cash settlement process;

The FBOT must agree to promptly notify the CFTC of any change to the information it makes available to the public with respect to the linked contracts or to speculative positions limits;

The FBOT must provide the CFTC with information on large traders in the linked contract comparable to the large trader reports filed with respect to positions in the U.S. market, including information which is necessary to complete, and which can be included in, the commission’s aggregation of market information contained in its “Commitment of Traders” reports.4

FBOTs that previously have been given permission to permit U.S. members to directly access their markets will have 180 days before these provisions become effective.

Section 725 of the proposed OTC Act of 2009 also contains provisions making clear that, so long as a U.S. intermediary has reason to believe that a contract has been entered into on or subject to the rules of an FBOT that has complied with the registration and contract-specific requirements of the OTC Act of 2009, the intermediary will not be liable for a violation of the Commodity Exchange Act’s prohibition on trading off-exchange futures contracts. Finally, the provision also provides that contracts traded on an FBOT shall not be void or voidable by the parties executing such contracts based on the failure of the FBOT to comply with these provisions.

What will the effect of these changes be on non-U.S. futures markets?

If this section of the OTC Act of 2009 is enacted as proposed, the current CFTC staff no-action process will be replaced by the requirement that FBOTs wishing to permit U.S. members direct market access register with the CFTC. Secondly, any FBOT that permits direct market access by U.S. members or market participants to contracts that settle to the price of a U.S. traded or cleared contract will be required to meet certain information, reporting and position limit requirements, with respect to such linked contracts. These information, reporting and speculative position limit requirements may or may not be consistent with existing law, custom and market practice in the FBOT’s home jurisdiction.

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